Quantitative Tightening

But wait, what? Quantitative tightening? Was it not supposed to be quantitative easing? Well, no. It’s the reverse. Quantitative easing is an unconventional monetary policy of buying financial assets in the market, which increases central bank reserves beyond the level needed to keep the short-term interest rates at zero. It was the central banks’ response to the Great Recession.

However, as the economy recovered, the Fed started to normalize its monetary policy. Initially, it began tapering, i.e., slowly reducing the amount of money it puts into the economy. As investors worried about the effects of a reduced monetary stimulus, the bond yields spiked. The period of market turmoil after Ben Bernanke announced the Fed’s intention to taper, was called “taper tantrum”. In 2014, the Fed ended buying new assets, but it still reinvested the interests and principal payments received from the bonds held on its massive balance sheet. And finally, in October 2017, the U.S. central bank started unwinding of its balance sheet. The program was called “quantitative tightening” to emphasize that it was the reversal of the previous quantitative easing.

Quantitative Tightening and Gold

As quantitative easing injected liquidity into the markets, it was positive for the asset prices. On that basis, many analysts worry that the quantitative tightening, which drains liquidity from the markets, will be negative for them, especially that it is also unprecedented program. While gold may shine. Is it really true? Well, not. Why? First of all, the unwinding of the Fed’s balance sheet was well telegraphed in advance and thus widely expected and already discounted by the markets. Secondly, the U.S. central bank is not going to reduce its balance sheet to the pre-crisis level. Thirdly, the pace of tightening has been very gradual, running quietly on autopilot in the background, as the Fed remembers the taper tantrum and is moving now with extreme caution. Indeed, as the chart below clearly shows, the Fed’s balance sheet, as of June 2018, has declined merely 3 percent from October 2017 when the quantitative tightening started.

Chart 1: The Fed’s balance sheet (in trillions of $) from 2003 to 2018.

The implication is clear: the effects of the quantitative tightening will not be simply the reverse of the quantitative easing. We expect smaller impact, especially given economic expansion and favorable financial conditions. It means that the quantitative tightening should not be the potential trigger of market turmoil which would send gold prices higher. Actually, if there is any impact on the gold market, it should be rather negative, as the Fed’s tightening could lift the real interest rates – and gold usually struggles when yields are increasing.